The Sharia Finance Model as an Ethical Alternative to Conventional Banking

The financial crisis of the past decade has driven a gradual movement towards more equitable forms of banking. For instance, stricter regulations on capital requirements and consumer disclosure standards have been introduced as measures to prevent financial malpractice and predatory lending. However, many of these regulations are indiscriminate, and acts as a drag on the financial markets. More onerous is the accusation that regulations fail in creating an egalitarian system as capitalism and ethics are antithetical. Using the Deontological and Utilitarian frameworks, I will propose that the corporate structure of conventional banks often create an environment where immoral practices are promoted, and adherence to regulations are ineffective due to the complexity of enforcement. A rules-based approach cannot be a sustainable method of establishing an ethical financial market. On the other hand, Sharia Finance has often been heralded as an enlightened system due to the adherence to its Maqasid al-Shari’a (higher purposes). This paper aims to establish the Sharia Finance model as an ethical alternative to conventional banking and explore the feasibility of it’s implementation.

Islamic Banking and Finance (IBF) can be best described as a financial system that adhere to a set of religious rules called the Shari’ah that are defined by the Quran (Divine words of God), Sunnah (Teachings of the Prophet) and the Ijma (Consensus of Muslims). These rules mostly consist of restrictions on the ability of financial institutions to act in the best interests of their shareholders and were formed largely as a response to mercantilism in the late-Babylonic Middle-East.

IBF explicitly prohibits the taking of Riba, which in its broadest sense refers to usurious practices taken on by lenders that profit them at the expense of borrowers. Moreover, IBF discourages Gharar (contractual uncertainty) and Qimar (speculative activities), as risk-taking was generally frowned upon by the nomadic ancestors of Muslims. Additionally, loans to companies involved in the pork, drugs and cigarettes industries are also prohibited. The above-mentioned principles of IBF are restrictive in nature and limits the ability of Islamic Banks from borrowing and lending like a conventional bank would. Hence, bankers and scholars have adapted and devised several products largely based on the conventional model but modified in a way to comply with the Sharia regulations. At the heart of these products and restrictions, lie an ardent desire to promote ethical outcomes for the Muslim communities.

As this essay’s hypothesis concerns finding an ethical alternative to banks across ethno-religious backgrounds, theories relating to ethical relativism and divine command ethics are irrelevant and will not be considered. Instead, I will focus solely on critiquing it from the lenses of Rawlsian deontology and utilitarianism – 2 contrasting school of thought regarding morality.

Rawls theory of justice is a deontological theory, and within his theory of justice, lies the “difference principle”, which posits that society has a responsibility to alter the distribution of goods to provide for members who are less fortunate (Wenar, 2017). In this regard, IBF’s belief in aiding the under-privileged in the form of Zakat (religious taxes) is therefore ethically justified. Unlike most conventional banks, IBFs dedicate a portion of their loan book to the Qard-al-hassan, or benevolent loans (Iqbal & Shafiq, 2015). These funds are specially set aside entities that strives to provide interest free loans to serve social objectives and are most often used towards poverty alleviation. These loans do not reap the IBFs any monetary benefits and are backed only by the goodwill of borrowers rather than collateral. In stark contrast, many microfinance institutions that provide loans to unsecured borrowers are doing so out of profit, and regularly charge usurious rates with the global average standing at about 35% per annum (CGAP, 2008). Although Microfinance Institutes and Islamic Banks both provide loans to impoverished borrowers, they differ significantly when we assess the motivations that underpin their business model. Admittedly, only a portion of Islamic funds (Samad, 2012) are devoted to the Qard, but the motives behind its conception and the its universality amongst IBFs (Kazem, 2015) is evident of IBF’s keenness in promoting an egalitarian society.

This principle of justice is continuously emphasized across IBF’s other prohibitions. Gharar for instance, is defined as being present in transactions where consumers are unaware of details of the products purchased. The banning of Gharar aims to alleviate the information asymmetry between buyers and sellers, and thereby protect consumers from predatory merchants. Many conventional banking products like the collateralized debt obligations (CDOs) sold to retail investors would have been considered Gharar for the simple fact that their payoffs were largely dependent on extremely huge bundles of mortgages that would not have been easily accessed by consumers (Abbas J, 2015). Without the ability for investors to understand the individual details on these mortgages, it is very hard for them to assess the risks involved in investing in CDOs and the presence of this information asymmetry would be ethically unjustified from the perspective of Rawlsian deontology. Under an IBF model, products like CDOs and others of a derivative nature like investment-linked life insurance would be forbidden, and investors seeking to participate in capital markets would be sold only transparent and easily-understandable products.

These points highlight how Islamic Banks are guided by ethical principles, which ensures it prioritizes its responsibility to promote distributive justice.

Alternatively, we can also judge the ethicality of IBF through its outcomes by the utilitarian approach. In this, the ultimate goal of any model is to maximize utility for the greatest number of people (Al Hasan, etal., 2013). At first glance, it seems that the restrictive nature of Islamic Banks would serve as a detriment to economic development. However, empirical data from the IMF shows that there is a positive correlation between IBF development and increases in GDP (Imam & Kpodar, 2015). Moreover, as Islamic Banks were not permitted to invest in Gharar or risky instruments, there was a far muted risk of bank failures during financial crisis (Hasan & Dridi, 2010). The virtuous effects of these are significant, as bank failures are likely to spillover to other creditors and even other industries as demonstrated by the 2008 recession.

In addition, many established IBFs have the same level of profitability as their conventional counterparts, albeit having dissimilar sources of revenue – the former through the sharing in revenues of ventures and the latter through interest generated from lending activities. Yet, IBFs achieve more ethical outcomes through their non-predatory modes of lending. As the pursuit of ethical outcomes as interpreted by religious teachings is synonymous with the maximization of profits for its shareholders, we can identify IBF as an integrated model for Corporate Social Responsibility.

In this context, IBF’s alternative avenue of profits proves how the pursue of profit may not necessarily be in contradiction to the produce of social good. While this could be classified this as a rare situation where corporations take the socially responsible course of action because it is simultaneously able to meet the profitability criteria (Banerjee, 2008), the complementary ends are far from coincidental. Instead, it is the result of placing social good instead of profit maximization as the end in mind, then deriving the plausible means, the financial workaround to achieve this end. It does not reduce social good to an unconfirmed by product that is more likely to be produced from single-minded profit maximization allied with an appropriate framework of law (Friedman, 1970).

The combination of these would indicate that Islamic Banks does provide greater utility for the economy as a whole. If we also consider the distributive features of IBF as described in the previous section, we can then conclude that IBF is more ethical as it provides more utility for a greater number of people.

Now that we have evaluated the morality of the operations of Sharia banks in comparison to conventional banks, we explore the limitations of IBF that have prevented secular societies from adopting it.

Although IBF was designed with the prohibitions on interest and excessive uncertainty, many products of the modern version of IBF are designed to mimic conventional banking products. For instance, Murabaha is an Islamic debt instrument that mimics the conventional asset-backed loans in essence but circumvents the prohibition on interest by adjusting the principal repayable upwards (similar to a zero-coupon bond). Some Murabaha contracts even include periodic payments and labelled these interest payments as “principal repayments” (Copeman, 2012), ignoring the substance of the prohibition altogether. Although many other IBF products like Musharaka and Mudaraba are purely Islamic innovations, the vast majority of loans are of the Murabaha variant and results in more complicated and expensive transaction structures (Zandi & Mohd. Ariffin, 2012). Clearly then, IBF cannot be called ethical alternatives if its substance is identical to that of conventional finance products. It seems that actually being moral is neither a necessary nor a sufficient condition for being believed to be moral (Abend,2014).

The vast majority of IBF’s clients and employees are adherents to the Muslim faith, and whose motivations to comply with these laws are of an ontological-nature. Moreover, as most of IBF’s principles are based on hadiths or religious texts which seeks to command believers rather than to provide sound explanations, it would be hard for non-adherents to the faith to be convinced by these beliefs. If we were to consider IBF as a reliable alternative, only portions of IBF’s principles that can be justified in a secular manner should be applied.

As many of the principles behind IBF are based on the teachings of the Prophet in the 13th century, many of them do not consider innovations and changes in our modern society. For instance, the amount of cross border trade has increased tremendously, and our financial markets are extremely intertwined. By imposing restrictions based along religious lines, cash movements between Islamic and non-Islamic entities might be hindered. Moreover, the prohibitions on Gharar or risky products might actually be counter-intuitive, as the evolution of risk-based products like derivatives were developed mainly as a way for entities to reduce their exposure to risk through hedging. By banning the use of derivatives to hedge against naturally occurring risks, an entity cannot adequately protect its shareholders by mitigating these risks.

Evidently, the current Sharia model is ethical in principle, but cannot simply be transplanted onto secular societies in its current form, because it remains lacking when translating its virtuous intentions into practicable actions. Nevertheless, there remains some utility in the Sharia model, particularly when certain elements within the model can be isolated and applied to conventional banks.

Currently, most conventional banks derive the bulk of their revenue from the interest generated from lending activities. However, under the sharia model, banks are largely compensated through the sharing in revenues of ventures. These forms of partnerships are akin to equity stakes and have been shown, via quantitative studies, to be beneficial to lenders and creditors (Gonzalez, 2016). For instance, Smith and Warner (1979) argues that equity stakes will encourage banks to permit a greater level of risk, thereby reducing the risk of under-investment. Moreover, with a greater interest in the success of the company and the ability to obtain more information about their operations, the quality of due diligence conducted by banks would be enhanced (Park., 2000). Clearly, the ethical principles behind sharia’s ban on usurious loans does not deny positive economic externalities and thus, can be an element that local banks can progressively adopt to increase shareholder returns.

The Tulip Mania and the speculative activities in the real estate sectors are examples that speculative activities can be key contributors to financial instability (Wen & Wang, 2009). In particular, the prevalence of CDS (Credit Default Spreads) and the accompanied lack of equity capital backing them have been widely held to have contributed to the collapse of several banks and insurance firms during the 2008 financial crisis (Jarrow, 2011).

IBF, on the other hand, regards speculative activities as Maysir (gambling), which the Quran forbids because it intrinsically brings about an unequal distribution of wealth (Ar, 2016). The conventional banking system can place greater curbs on the level of speculative activities undertaken, and perhaps untie the compensation structure of top executives from the fickle speculative segment of banks. Drawing upon IBF’s prohibitions, our model can include proactive measures to limit the scale of speculative trading. These will serve to discourage hedging instruments like CDS from being mis-used as speculative instruments, therefore contributing to a more stable financial system (Chapra, 2011).

Another interesting feature within IBF is the ban on loans made out to haram (forbidden) industries such as trades involving pork, tobacco and drugs, while encouraging the disbursement of qard hasan loans that are interest-free to needy members of the community. Conventional banks on the other hand, take a much softer touch on ethical lending and only bars loans from being made out to illicit organizations. Companies like cigarette manufacturers that produce negative societal externalities can easily obtain loans from any conventional banks to invest in new factories or expand its distribution and marketing networks.

Regulators can thus mimic the IBF concept of selectively promoting and discouraging industries by their value to society, so as to complement the existing suite of Pigouvian taxes which have demonstrated itself to be less than effective in changing consumer behaviors (Pearl, Boisclair, & Ferrence, 2011). One avenue could be to charge fees and provide subsidies for banks based on the magnitude of externalities brought about by their operations. Not only will this hinder the growth of harmful industries, beneficial ones like charitable institutions will benefit from the lowered borrowing costs.

It is often said that there is “no need to reinvent the wheel”. However, even though our financial system has evolved over many centuries and developed in complexity and efficiency, it pales in comparison when assessing its contributions to the furthering of societal welfare. The new model proposed include processes to discriminate between socially beneficial and unproductive industries as well as partnerships between banks and lenders on ventures, which intrinsically promotes ethical decision making.

The adoption of a religious approach to regulating banking activities is not only confined to Islamic societies. Quakers too have long sought to apply the egalitarian aspects of their faith throughout the banking sector. This includes restricting their credit lines to only sectors that adhere to their religious convictions, a practice similar to IBF’s ban on lending to haram entities. Their approach to establishing integrity and mutual trust too, have contributed to the ascent of Quaker financial institutions like Barclays and Lloyds (Plender, 2012), and demonstrates the utility of certain religious ideals in establishing a competitive edge for financial institutions.

Nevertheless, in the centuries that followed the founding of these Quaker banks, many have lost their ethical grounding in an increasingly competitive market. Notably, Barclays and Lloyds have both been embroiled in scandals over rate-rigging, fraudulent misrepresentations of products and corporate excesses. Hence, for IBF to contribute meaningfully to a more ethical financial system, managers have to themselves stay rooted to the principle values of which the very system stems from.